Top sectors to watch in Q3

by Denise Chisholm, Director of Quantitative Market Strategy, Fidelity Investments

Energy and consumer discretionary stocks could be poised to lead.

Key takeaways

  • While all sectors fell during the second quarter, defensive sectors held up the best, with consumer staples, utilities, and energy stocks suffering the smallest losses.
  • Energy stocks have strong momentum and could continue to outperform even if oil prices fall from here.
  • Although consumer discretionary stocks fared poorly in the second quarter, they could outperform this quarter if negative consumer sentiment turns out to be overdone.

The second quarter of 2022 proved challenging for investors, as worries over inflation, Federal Reserve policy, and recession risk weighed on markets. Not only did the broad market indexes decline during the second quarter, but each of the 11 major sectors posted negative returns during the period.

While macroeconomic concerns are still on many investors’ minds as the second half of the year begins to take shape, it’s also possible that so much worry could lead to some surprises on the upside. Read on for notable sector trends to potentially watch over the next few months.

Performance summary: Rotation to defensives continued

All sectors posted negative returns during the quarter, as interest rates rose and investors became more concerned about the possibility of recession. Consumer staples, utilities, and energy stocks had the smallest losses, while consumer discretionary, communication services, and technology were the bottom performers for the quarter.

Past performance is no guarantee of future results. Sectors defined by the Global Industry Classification Standard (GICS®); see Index Definitions for details. Performance metrics reflect S&P 500® sector indexes. Changes were made to the GICS framework on 9/24/18; historical S&P 500 communication services sector data prior to 9/24/18 reflect the legacy telecommunication services sector. The top 3 performing sectors over each period are shaded green; the bottom 3 are shaded red. It is not possible to invest directly in an index. All indexes are unmanaged. Percentages may not total 100% due to rounding. Source: Haver Analytics, Morningstar, FactSet, Fidelity Investments, as of 6/30/2022.

Scorecard: Constructive outlooks for energy and health care

Relative strength and a solid combination of valuations and fundamentals make the energy sector look appealing, while cheap valuations support the outlook for health care. High valuations may challenge the backdrop for consumer discretionary; however, some contrarian indicators appear increasingly more constructive for the sector. Meanwhile, weak fundamentals and relatively high valuations constrain the outlook for utilities.

Past performance is no guarantee of future results. Strategist view, fundamentals, valuations, and relative strength are based on the top 3,000 US stocks by market capitalization. Sectors defined by the GICS; see Index Definitions for details. Historical communication services data has been restated back to 1962 to account for changes to the GICS framework made on 9/24/18. Strategist view is as of the date indicated based on the information available at that time, and may change based on market or other conditions. This is not necessarily the opinion of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Overweight and underweight views represent opportunistic tilts in a hypothetical portfolio relative to broad market sector weights. Sector weights may vary depending on an individual’s risk tolerance and goals. Time horizon view factors are based on historical analysis and are not a qualitative assessment by any individual investment professional. The top 3 sectors based on each time horizon view metric are shaded green; the bottom 3 are shaded red. See Glossary and Methodology for details. It is not possible to invest directly in an index. All indexes are unmanaged. Source: Haver Analytics, FactSet, Fidelity Investments, as of 6/30/2022.

Fundamentals: Materials, tech, and communication services led

Materials again led the fundamentals rankings, coming in second in earnings per share and EBITDA growth. Technology and communications services also scored well. Utilities was the worst-performing sector, coming in eighth in earnings-per-share growth and ninth in EBITDA growth. Financials and consumer staples also posted relatively poor fundamentals.

Past performance is no guarantee of future results. EPS = earnings per share. EBITDA = earnings before interest, taxes, depreciation, and amortization. * EPS growth over the last 12 months for energy was -230%; EBITDA Growth for energy over the same period was 272%. The financials and real estate sectors are not represented in the EBITDA growth or free-cash-flow margin charts because of differences in their business models and accounting standards. See Glossary and Methodology for further explanation. Sectors based on the top 3,000 US stocks by market capitalization and defined by GICS. Communication services data restated back to 1962. Source: Haver Analytics, Fidelity Investments, as of 6/30/2022.

Valuations: Financials, health care, communications look cheap

Financials ended the quarter as the sector with the least-expensive valuation, in aggregate, with the lowest relative price-to-book and price-to-earnings ratios. Health care and communications services also looked relatively inexpensive. Consumer discretionary, utilities, and industrials were the most-expensive sectors.

Past performance is no guarantee of future results. Free-cash-flow yield reflects free cash flow divided by market price per share; it is the inverse of the price-to-free-cash-flow ratio. Historical range excludes the top and bottom 5%. Green or red circles indicate if current levels are below or above the historical average, which excludes the top and bottom 5%. The financials and real estate sectors are not represented in the free-cash-flow yield or price-to-sales charts because of differences in their business models and accounting standards. See the Glossary and Methodology for further explanation. Historical range since January 1962. Sectors based on the top 3,000 US stocks by market capitalization and defined by GICS. Communication services data restated back to 1962. Source: Haver Analytics, Fidelity Investments, as of 6/30/2022.

Relative strength: Momentum in energy, utilities, and materials

The energy, utilities, and materials sectors exhibited the greatest relative strength over the past 6 months. Information technology was the weakest, followed by consumer discretionary and communication services.

Past performance is no guarantee of future results. Relative strength compares the performance of each sector with the performance of the broad market, based on changes in the ratio of the securities’ respective prices over time. See Glossary and Methodology for further explanation. Charts represent performance of sectors based on the top 3,000 stocks by market capitalization relative to the Russell 3000 Index. It is not possible to invest directly in an index. All indexes are unmanaged. Source: FactSet, Fidelity Investments, as of 6/30/2022.

Inflation appears likely to decelerate

There are huge gaps between the 3 main inflation indicators: headline Consumer Price Index (CPI), core CPI (which excludes food and energy prices), and the core Personal Consumption Expenditure (PCE) deflator (which measures changes in personal consumption). Historically, these indicators tend to converge to the core PCE deflator, which had a 3-month rate around 4% during the quarter. Weaker inflation may be constructive for stocks.

Past performance is no guarantee of future results. Inflation measures shown are 3-month moving averages. Analysis based on S&P 500 returns. Core PCE deflator data through April 2022. Source: Bureau of Labor Statistics, Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

Rising mortgage rates put downward pressure on CPI growth

There’s a big reason year-over-year increases in CPI could slow: The index is heavily weighted toward housing. Mortgage rates are up the most since the early 1980s, and housing prices have almost never accelerated after comparable increases in mortgage rates. Slowing growth in housing prices would make inflation more likely to decelerate.

Past performance is no guarantee of future results. Source: Federal Home Loan Mortgage Corporation, S&P CoreLogic Case-Shiller US National Home Price Index, Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

Recession isn’t a sure thing

Bond prices suggest the market expects the Federal Reserve (Fed) to raise the federal funds rate by almost 350 basis points this year. A hike of this size is unusual, historically, occurring in just 2% of 12-month periods since 1962. Even in the rare scenarios when the Fed has hiked between 300 and 350 basis points, GDP has increased 80% of the time that year and 60% of the time the following year.

Past performance is no guarantee of future results. Frequencies reflect percentages of all 12-month periods from 1962 to present. GDP: Gross domestic product. Source: Haver Analytics, FactSet, Fidelity Investments, as of 3/31/2022.

Rising energy prices may not obstruct demand

Many investors worry that rising energy prices will put a damper on consumer spending. This may not be the case. The reason: Wages are rising too, so energy remains less than 5% of consumers’ income. That’s lower than the historical average, and below levels that have prevailed during most of the 21st century.

Past performance is no guarantee of future results. Wage analysis based on Atlanta Federal Reserve data as of June 9, 2022. YoY: year over year. Final data point (right) based on a regression of gasoline prices to account for a lag in data. Source: Haver Analytics, FactSet, Fidelity Investments, as of 6/20/2022.

Rotation to defensives suggests a market advance

A huge rotation into defensive stocks has pushed them close to top-decile valuations relative to the broad market. Historically, when defensive sectors’ relative valuations have increased by more than 15% and are in their top quartile, the overall market has advanced over the next 12 months 100% of the time, for an average gain of 22%.

Past performance is no guarantee of future results. Price-to-earnings (P/E) Ratio: The ratio of a company's current share price to its reported earnings. Reval: Revaluation (increase in relative valuation.) Defensive sectors: consumer staples, health care, and utilities. Analysis based on the top 3,000 US stocks by market capitalization. Source: Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

Energy earnings may be underestimated

If the market is overestimating the impact of inflation, is it time to sell energy stocks? I don’t think so. Crude prices could stay high even if headline inflation decelerates. Moreover, analysts have vastly underestimated energy company earnings this year—by an average of 10% per month, based on revisions to analysts’ earnings estimates.

Past performance is no guarantee of future results. Change in forward-earnings estimates based on revisions to analysts’ estimates. Analysis based on the top 3,000 US stocks by market capitalization. Source: Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

With a jump in earnings, energy stocks look cheap

The huge leap in energy companies’ earnings outlooks has made energy the cheapest sector in the market based on forward price-to-earnings ratios. Historically, when energy stocks have been this cheap, they have tended to outperform the market over the next 12 months, whether crude oil prices have gone up or down.

Past performance is no guarantee of future results. Forward price-to-earnings (P/E) Ratio: The ratio of a company's current share price to its earnings. A forward P/E ratio typically uses an average of analysts’ published earnings estimates for the next 12 months. Analysis based on the top 3,000 US stocks by market capitalization. Source: Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

Bad news may be priced into consumer discretionary stocks

In the consumer discretionary sector, valuation spreads—the valuation difference between the cheapest and most expensive stocks—have reached the top quintile of their historical range, based on book value-to-price ratio. Wide valuation spreads tend to be a signal of fear; however, the sector has been likely to outperform the market over the next 12 months after reaching comparable levels, historically.

Past performance is no guarantee of future results. Valuation spread as measured by book value-to-price ratio (the ratio of a company’s reported accumulated profits and capital to its share price). Analysis based on the top 3,000 US stocks by market capitalization. Source: Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

Low consumer sentiment may provide a boost

Consumer sentiment is terrible, near the very bottom of its historical range. In the past, bad news for sentiment has been good news for consumer discretionary returns. Consumer discretionary stocks have outperformed the market over the next 12 months every time consumer sentiment has been this low.

Past performance is no guarantee of future results. Analysis based on the top 3,000 US stocks by market capitalization. Source: University of Michigan, Haver Analytics, FactSet, Fidelity Investments, as of 5/31/2022.

 

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